A world off-balance on monetary policy

Nouriel Roubini writes:

Nouriel Roubini: “Worries about a hard landing in China… China is more likely to have a bumpy landing than a hard one…

…[but] investors’ concerns have yet to be laid to rest…. Emerging markets are in serious trouble…. The Fed probably erred in exiting its zero-interest-rate policy in December…

And it is not clear how the Federal Reserve can correct what is now widely-recognized as a probable error.

First, the Federal Reserve would have to be willing to admit that the asymmetric loss function meant that exiting zero last December was a probable error.

It was a probable error in retrospect today, and was unwise in prospect last December. Right now we are worried about global deflation. It is difficult to envision an alternative counterfactual scenario today in which we are equally worried about global inflation and equally regret that the Federal Reserve did not exist zero last December. When there is a substantial loss associate with a Type A error and only a minor loss associated with a Type B error, one risks making the Type B error unless the odds are overwhelming. The odds last December were to overwhelming.

The problem for the Federal Reserve is that admitting it made a policy error last December requires an all-but-explicit climbdown from the last two years’ worth of public risk judgments, and an explanation of why, given the obvious asymmetries, those public risk judgments were explained. And there is no face-saving way to undertake such a climbdown.

Second, the Federal Reserve would have to take steps to neutralize the contractionary pressure its policy move in December and the previous telegraphing of that move have put on the world economy. And that would be a difficult task indeed.

It looks like Ben Bernanke is about to go through the options. And that will definitely be worth reading.

March 22, 2016


Brad DeLong
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